Fed Will Remain One Step Behind Supporting Reflation… For Now

Bill Ehrman

6 Mar 2017

While it was a very eventful week from Trump’s address to Congress to strong data points both here and abroad to changes in China’s financial leadership and more, the key event for me was Janet Yellen’s speech and follow-up question and answer period in Chicago on Friday. I find her smart, straightforward, pragmatic and a very nice person. My key takeaway was that the Fed will raise rates in March, global growth has improved since December, business and consumer optimism has risen dramatically since the election, AND the Fed will wait to see the impact of whatever new fiscal, tax and regulatory policies are enacted in DC before altering the Fed’s longer term view on economic growth and interest rates. The Fed will continue to look through the rear-view mirror staying one step behind as the U.S. economy accelerates later in the year into 2019. The investment implications are straightforward: the yield curve will continue to steepen, the dollar will strengthen further and the U.S. stock market can continue to rise led by the reflation beneficiaries while the past winners will fall behind and under-perform.

Let’s get specific about each major event that occurred last week:

1. Donald Trump gave probably his most scripted speech ever on Tuesday night when he addressed Congress and reviewed his agenda point by point, which included: huge business and individual tax cuts; major increases in the defense budget; a $1 trillion dollar infrastructure program “Made in America”; a new healthcare plan improving quality and reducing cost, especially for drugs; new trade policies with “America First” ; major changes in immigration; improvements in the educational system; and sharp reductions in regulations. Naturally all of this was said with broad strokes and a lack of specifics. He emphasized that he will keep his promises made during his campaign and Washington will never be the same. Let’s hope so!

2. Economic statistics virtually everywhere in the world got stronger last week. The strong numbers out of the Eurozone particularly surprised me especially with a sharp increase in inflation. Even Japan is coming out of the doldrums. China is having its planning session this weekend, and I expect their growth target for 2017 to be around 6.5%. Let’s not forget India, the second largest nation in the world, where it was reported that fourth-quarter growth was 7%, slightly higher than earlier forecasted. Growth should exceed 6.5% in 2017-18. Australia strengthened too. The bottom line is that global growth will continue to accelerate as we move through 2017 into 2018 supporting the reflation thesis. Inflation will rise too.

3. China continues to deal with its financial problems, specifically too much leverage and too many zombie companies. We expect to hear more about changes in its leadership of its banking sector shortly to deal specifically with these issues. The government just announced its intention to further reduce capacity in its steel, aluminum and phosphate sectors. Let’s see the follow-through as I have heard that before, but it seems more likely true today with the Trump administration’s focus on dumping and government subsidies. In fact, additional anti-dumping penalties were announced Friday against China’s steel industry. I expect a similar ruling this spring against China’s aluminum industry.

4. This all brings me be back to the Fed, Janet Yellen’s speech and question/answer period on Friday and the ECB and BOJ. Many of the Fed governors have been giving speeches over the last week or so as the Fed entered a quiet period Saturday with a Fed meeting in two weeks. The Fed is clearly concerned about its image as it has been under attack by Trump, so I feel that its members wanted to get out there and state that it is ahead of the curve rather than behind it as Trump has said. The truth is that normalization is not 0.75%, 1% or even a 1.25% fed funds rate with an economy expanding by 2+% and inflation even at 1.75%. The Fed’s balance sheet is bloated too, as we know. It is paramount that the Fed sets a course to normalize rates and reduce its balance sheet so that it has flexibility to act down the road if needed. It is just as clear that the Fed along with the ECB and BOJ don’t want to act prematurely and take the punch bowl away too early. That’s the line all of them have to walk. It is apparent that all of the monetary authorities will let the economies run much more before really taking aggressive actions, as they still fear the downside more than the upside. Unfortunately they are all looking through the rear-view mirror rather than the windshield. They are worried about acting prematurely. While all of this is good for the financial markets now, we have to watch and see what happens down the road in 2018.

The bottom line is that the Fed, ECB and BOJ will all remain one step behind for the foreseeable future, which is good for stocks in general but not bonds. It is also good for the dollar and commodities. We favor investing in the U.S. at this time as Trump’s policies, “Make America Great Again” and “America First” as enacted will benefit U.S. domiciled companies for a multitude of reasons mentioned in previous pieces. The reflation beneficiaries include industrials, technology, financials, commodity and capital goods stocks; while I would continue to sell/short the old winners including consumer non-durables, consumer durables, utilities, Reits and large pharma. Patience will be rewarded, as none of this will happen overnight.

I want to make a few additional comments about Warren Buffett after listening to him in an interview last Monday. While he actually invested $12 billion right before the election, he added much more right after it. Berkshire is a clear beneficiary of lower taxes and reduced regulations. It has been estimated that Berkshire’s book value could be revised upwards by over $27 billion alone due to Trump’s proposed changes. Warren and his team are true active investors.

The stock markets continue to rise on a wall of worry and skepticism. There is no euphoria at all but total amazement and distrust. That’s all good!

So remember to review all the facts; pause, reflect and consider mindset shifts; review your asset allocation and risk controls; do in-depth independent research and…